Monday, July 14, 2014

Since last March I've been tracking the confluence of a reduction in the growth of bank savings deposits, the pickup in bank lending, and the Fed's tapering of its QE3 program ("Tracking the perfect storm"), looking for signs of declining money demand that the Fed might be underestimating. The Fed recently told us that tapering will finish within 3 months; bank lending continues to be strong; but bank savings deposit growth has not slowed further. Althought there's no evidence of any further significant decline in money demand, these all remain symptomatic of a slow and gradual decline in the demand for money and money equivalents. As such, it is appropriate for the Fed to taper its QE purchases (which were designed primarily to satisfy the world's seemingly insatiable demand for money and money substitutes, since bank reserves are now functionally equivalent to T-bills), and there is no reason at this point to worry about any unexpected consequences from the end of QE3.

The two graphs above show the level and the 6-mo. annualized growth rate of bank lending to small and medium-sized businesses. Since the end of last year, C&I Loans are up by about $130 billion, for a 16.5% annualized growth rate. That's the fastest growth we've seen since the recession. This is a good reflection of increased confidence on the part of banks and businesses, and it is also symptomatic of an important decline in the demand for money. C&I Loan growth had slowed a bit in recent months, but last week's surge in C&I Loans put to rest any notion that bank lending is not moving forward at speed.

The two graphs above show the level and the year over year growth rate of bank savings deposits, which have grown by almost $3.4 trillion since the onset of the 2008 financial crisis. Since the end of last year, this component of the M2 money supply has grown at a 5.5% annualized pace, which is somewhat slower than the 7.1% annualized growth of M2 over the same period; it is definitely slower than what we have seen in recent years. I think this is symptomatic of a world that is somewhat less anxious to accumulate safe assets that pay almost no interest. Money demand today is not what it used to be, but it is still reasonably strong.

Meanwhile, the demand for gold and 5-yr TIPS has been relatively steady for the past year or so, after falling significantly beginning in late 2012/early 2013. Both of these reflect a moderate decline in the demand for safe assets. Gold and TIPS are even better than money, because they can offer protection from inflation that pure money can't.

Not much has changed in recent months, but it's still notable that bank lending is increasing at a relatively brisk pace. At best this is a reflection of increasing confidence; at worst it's a harbinger of some modest inflation pressures.

If my thesis about the demand for money and other safe assets declining is correct, then gold is going to fall further. Moreover, I observe that the average real price of gold over the last century is around $600. At current levels, gold still appears to be quite expensive, and I believe it is priced to a lot of inflation that has yet to occur.

The other explanation of QE is that it puts cash into the hands of investors who sell the Treasuries to the Fed.

Those sellers then put the money into stocks, bonds, or property, or spend it--all good.

As Scott Grannis points out, some of that QE money seems to end up in banks, who sit on it. So QE was somewhat neutralized. But enough worked its way into the economy to do some good.

Probably QE should have been more aggressive, sustained and robust starting immediately in 2008. But, as "unconventional" policy, the Fed was rather timid in its use of QE. There was hysterics too from the righty-tighties.

With some a timid Fed, I think our central bank is actually taking a reckless course. Why?

Recoveries do not last forever. We may hit the next recession with 1 percent inflation, and US Treasuries trading around 2.5 percent (10-year).

In quick order, the Fed will be out of ammo. Once banks stop lending, you will see real estate collapse. Guess what? Another bad recession---unless the Fed goes again quick and hard to QE.

The problem is, QE is still regarded as unconventional, and as "debasing the currency" etc by certain ideologues and extremists, who seem to have large megaphones.

In a world of bountiful capital, we probably need higher inflation targets, or a system of monetary policy known as Market Monetarism.

I'm in general agreement with Tamny on this. Particularly troubling is the Fed's conceit that it alone knows what the "right" level of short-term rates is. I think this rate should be determined by the confluence of market forces. To give due credit to the Fed, history shows that the Fed has not often made mistakes; inflation has been low for the past several decades and the economy has grown considerably. But when they do err, as they did in the mid-2000s, the consequences can be frightening.